Basel III limitations

• Basel III is the lack of a global Pillar 1 capital charge on interest rate risk on bonds held in the banking book.

• The Basel Committee has struggled with this since the 1990s. No capital charge was incorporated in Basel II although the committee was convinced that this is a significant risk which “merits capital”. In Basel III,

• The sharp divergence in the views of national supervisors once again prevented agreement on a capital charge.

Market risk factor

• To generate adequate returns as they reduce credit-risk exposures, banks and financial firms have tended to increase the duration of their government bond portfolios.

• Such regulation-induced substitution of interest rate risk for credit risk on their financial assets can lead to destabilizing market dynamics.

• There is evidence that institutional investors have recently increased in a pro-cyclical way the duration of their assets in response to a fall in long-term rates.

• Accounting conventions have not adapted well to a situation of the benchmark long-term interest being depressed by monetary and regulatory policy.

• International Accounting Standard 19 requires the calculation of the present value of defined-benefit pension liabilities, typically using a discount factor linked to a bond yield.

• The increase in the present discounted value of liabilities as bond yields fall encourages firms to increase the maturity of their assets.

• If pension funds all react by buying more longer-dated bonds, they could collectively magnify the initial interest rate shock.

• Given the rise in public debt since the GFC, governments need cheap finance.

• Through new rules, governments have in effect induced regulated lenders to limit credit risk from lending to the private sector but have acquiesced in their increased interest rate risk exposure from larger holdings of longer-maturity government bonds.

Macroeconomic development effect

• Macroeconomic developments in the advanced economies are also likely to push long-term rates higher.

• Growth forecasts in the US and a number of advanced economies are strong.

• With unemployment falling and financial markets buoyant, inflation may begin to surprise on the upside.